Table Of ContentCapital Budgeting
Financial Appraisal of
Investment Projects
DonDayananda,
RichardIrons,SteveHarrison,
JohnHerbohnandPatrickRowland
The Pitt Building, Trumpington Street, Cambridge, United Kingdom
The Edinburgh Building, Cambridge CB2 2RU, UK
40 West 20th Street, New York, NY 10011-4211, USA
477 Williamstown Road, Port Melbourne, VIC 3207, Australia
Ruiz de Alarcón 13, 28014 Madrid, Spain
Dock House, The Waterfront, Cape Town 8001, South Africa
http://www.cambridge.org
©Don Dayananda, Richard Irons, Steve Harrison, John Herbohn and Patrick Rowland
First published in printed format 2002
ISBN 0-511-03064-9 eBook (Adobe Reader)
ISBN 0-521-81782-X hardback
ISBN 0-521-52098-3 paperback
1 Capital budgeting: an overview 1
Study objectives 2
Shareholder wealth maximization and net present value 3
Classification of investment projects 4
The capital budgeting process 5
Organization of the book 9
Concluding comments 10
Review questions 11
2 Project cash flows 12
Study objectives 14
Essentials in cash flow identification 14
Example 2.1 15
Example 2.2 16
Asset expansion project cash flows 23
Example 2.3. The Delta Project 27
Asset replacement project cash flows 31
Example 2.4. The Repco Replacement Investment Project 32
Concluding comments 34
Review questions 35
3 Forecasting cash flows: quantitative techniques and routes 37
Study objectives 39
Quantitativetechniques:forecastingwithregressionanalysis;
forecastingwithtime-trendprojections;forecastingusing
smoothing models 39
More complex time series forecasting methods 49
Forecasting routes 51
Concluding comments 52
Review questions 53
4 Forecasting cash flows: qualitative or judgemental techniques 55
Study objectives 56
Obtaining information from individuals 56
Using groups to make forecasts 60
The Delphi technique applied to appraising forestry projects 64
Example 4.1. Appraising forestry projects involving new species 65
Example4.2.Collectingdataforforestryprojectsinvolvingnew
planting systems 66
Scenario projection 69
Example 4.3. Using scenario projection to forecast demand 70
Concluding comments: which technique is best? 71
Review questions 73
5 Essential formulae in project appraisal 74
Study objectives 75
Symbols used 75
Rate of return 76
Example 5.1 76
Note on timing and timing symbols 76
Future value of a single sum 77
Example 5.2 77
Example 5.3 78
Present value of a single sum 78
Example 5.4 78
Example 5.5 79
Future value of a series of cash flows 79
Example 5.6 79
Present value of a series of cash flows 80
Example 5.7 80
Example 5.8 80
Present value when the discount rate varies 81
Example 5.9 81
Present value of an ordinary annuity 81
Example 5.10 82
Present value of a deferred annuity 83
Example 5.11 83
Example 5.12 83
Perpetuity 84
Net present value 85
Example 5.13 85
Net present value of an infinite chain 85
Internal rate of return 86
Example 5.14 86
Loan calculations 87
Example 5.15 87
Loan amortization schedule 89
Concluding comments 89
Review questions 90
6 Project analysis under certainty 91
Study objectives 92
Certainty Assumption 92
Net present value model 93
The net present value model applied 95
Other project appraisal methods 96
Suitability of different project evaluation techniques 97
Mutual exclusivity and project ranking 102
Asset replacement investment decisions 108
Project retirement 109
Concluding comments 111
Review questions 111
7 Project analysis under risk 114
Study objectives 115
The concepts of risk and uncertainty 115
Main elements of the RADR and CE techniques 116
The risk-adjusted discount rate method 118
Estimating the RADR 118
Estimating the RADR using the firm’s cost of capital 119
Example 7.1. Computation of the WACC for Costor Company 120
Estimating the RADR using the CAPM 120
The certainty equivalent method 126
Example 7.2. Computing NPV using CE: Cecorp 127
The relationship between CE and RADR 128
Example 7.3. Ceradr Company investment project 128
Comparison of RADR and CE 129
Concluding comments 130
Review questions 130
8 Sensitivity and break-even analysis 133
Study objectives 133
Sensitivity analysis 134
Procedures in sensitivity analysis 135
Sensitivity analysis example: Delta Project 135
Developing pessimistic and optimistic forecasts 138
Pessimisticandoptimisticforecastsofvariablevaluesforthe
Delta Project example 141
Applying the sensitivity tests 144
Sensitivity test results 145
Break-even analysis 149
Break-even analysis and decision-making 150
Concluding comments 150
Review questions 151
9 Simulation concepts and methods 153
Study objectives 154
What is simulation? 154
Elements of simulation models for capital budgeting 156
Steps in simulation modelling and experimentation 158
Risk analysis or Monte Carlo simulation 162
Example 9.1. Computer project 163
Design and development of a more complex simulation model 171
Example 9.2. FlyByNight project 171
Deterministic simulation of financial performance 175
Example 9.3. FlyByNight deterministic model 175
Stochastic simulation of financial performance 177
Example 9.4. FlyByNight stochastic simulation 177
Choice of experimental design 179
Advantagesanddisadvantagesofsimulationcomparedwithother
techniques in capital budgeting 179
Concluding comments 180
Review questions 180
Appendix: Generation of random variates 181
10 Casestudyinfinancialmodellingandsimulationofa
forestry investment 185
Study objectives 185
Key parameters for forestry models 186
Sources of variability in forestry investment performance 187
Methods of allowing for risk in the evaluation of forestry investments 189
Problems faced in developing forestry financial models 190
Developing a financial model: a step-by-step approach 191
Example 10.1. Flores Venture Capital Ltd forestry project 192
Comparing forestry projects of different harvest rotations 199
Example10.2.FVCLtd:comparisonofone-stageandtwo-stage
harvest options 199
Risk analysis or Monte Carlo analysis 200
Example 10.3. Simulation analysis of FVC Ltd forestry project 200
Concluding comments 202
Review questions 203
11 Resource constraints and linear programming 204
Study objectives 206
LP with two decision variables and three constraints 206
Example 11.1. Roclap: product mix problem 206
Investment opportunities and by-product constraints 212
Example 11.2. Capital rationing problem 212
LP and project choice 214
Example 11.3. Project portfolio selection problem 215
Concluding comments 217
Review questions 217
12 More advanced linear programming concepts and methods 219
Study objectives 219
Basic LP assumptions and their implications for capital budgeting 220
Expanding the number of projects and constraints 221
Example 12.1. Power generator’s decision problem 222
Indivisible investments and integer activity levels 224
Example 12.2. Resort development problem 225
Borrowing and capital transfers 226
Example 12.3. Borrowing and capital transfer problem 226
Contingent or dependent projects 228
Example 12.4. Infrastructure problem 228
Mutually exclusive projects 229
Example 12.5. Sports gear problem 230
Some other LP extensions for capital budgeting 231
Concluding comments 233
Review questions 234
13 Financial modelling case study in forestry project evaluation 236
Study objectives 237
Forestry evaluation models: uses and user groups 237
Financial models available to evaluate forestry investments 238
The Australian Cabinet Timbers Financial Model (ACTFM) 239
Review of model development and design options 246
Concluding comments 249
Review questions 250
14 Property investment analysis 251
Study objectives 252
Income-producing properties 252
Example 14.1. Property cash flows from the industrial property 256
Example 14.2. Equity cash flows before tax from the industrial property 258
Example 14.3. Equity cash flows after tax from the industrial property 261
Corporate real estate 263
Example 14.4. Acquiring the industrial property for operations 263
Example 14.5. Leasing or buying the industrial property for operations 266
Development feasibility 268
Example 14.6. Initial screening of an industrial building project 268
Example 14.7. Project cash flows from a property development 270
Example 14.8. Equity cash flows from the development project 271
Concluding comments 272
Review questions 272
15 Forecasting and analysing risks in property investments 274
Study objectives 275
Forecasting 275
Example15.1.Forecastingoperatingcashflowsfortheindustrial
property 278
Example 15.2. Forecasting resale proceeds for the industrial property 283
Example15.3.Forecastingdevelopmentcashflowsfora
residential project 285
Risk analysis 288
Example15.4.Netpresentvalueoftheindustrialproperty–sensitivity
analysis 289
Example15.5.Overbuildingfortheindustrialproperty–scenario
analysis 290
Example 15.6. Development risks – Monte Carlo (risk) simulation 293
Concluding comments 293
Review questions 295
16 Multinational corporations and international project appraisal 297
Study objectives 298
Definition of selected terms used in the chapter 298
The parent’s perspective versus the subsidiary’s perspective 299
Example 16.1. Garment project 301
Exchange rate risk 303
Country risk 304
A strategy to reduce a project’s exchange rate and country risks 305
Other country risk reduction measures 309
Incorporating exchange rate and country risk in project analysis 310
Concluding comments 311
Review questions 311
References 313
Index 316
1 Capital budgeting: an overview
Financialmanagementislargelyconcernedwithfinancing,dividendandinvestmentdeci-
sionsofthefirmwithsomeoverallgoalinmind.Corporatefinancetheoryhasdeveloped
aroundagoalofmaximizingthemarketvalueofthefirmtoitsshareholders.Thisisalso
knownasshareholderwealthmaximization.Althoughvariousobjectivesorgoalsarepos-
sibleinthefieldoffinance,themostwidelyacceptedobjectiveforthefirmistomaximize
thevalueofthefirmtoitsowners.
Financing decisions deal with the firm’s optimal capital structure in terms of debt and
equity. Dividend decisions relate to the form in which returns generated by the firm are
passedontoequity-holders.Investmentdecisionsdealwiththewayfundsraisedinfinancial
markets are employed in productive activities to achieve the firm’s overall goal; in other
words, how much should be invested and what assets should be invested in. Throughout
thisbookitisassumedthattheobjectiveoftheinvestmentorcapitalbudgetingdecisionis
tomaximizethemarketvalueofthefirmtoitsshareholders.Therelationshipbetweenthe
firm’soverallgoal,financialmanagementandcapitalbudgetingisdepictedinFigure1.1.
This self-explanatory chart helps the reader to easily visualize and retain a picture of the
capitalbudgetingfunctionwithinthebroaderperspectiveofcorporatefinance.
Fundsareinvestedinbothshort-termandlong-termassets.Capitalbudgetingisprimar-
ily concerned with sizable investments in long-term assets. These assets may be tangible
items such as property, plant or equipment or intangible ones such as new technology,
patentsortrademarks.Investmentsinprocessessuchasresearch,design,developmentand
testing–throughwhichnewtechnologyandnewproductsarecreated–mayalsobeviewed
asinvestmentsinintangibleassets.
Irrespective of whether the investments are in tangible or intangible assets, a capital
investmentprojectcanbedistinguishedfromrecurrentexpendituresbytwofeatures.One
isthatsuchprojectsaresignificantlylarge.Theotheristhattheyaregenerallylong-lived
projectswiththeirbenefitsorcashflowsspreadingovermanyyears.
Sizable, long-term investments in tangible or intangible assets have long-term conse-
quences.Aninvestmenttodaywilldeterminethefirm’sstrategicpositionmanyyearshence.
Theseinvestmentsalsohaveaconsiderableimpactontheorganization’sfuturecashflows
andtheriskassociatedwiththosecashflows.Capitalbudgetingdecisionsthushavealong-
rangeimpactonthefirm’sperformanceandtheyarecriticaltothefirm’ssuccessorfailure.
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